What are assets? What are liabilities? What is equity?

Key Takeaways

• Assets are probable future economic benefits
• Liabilities are probable future economic sacrifices
• Equity Is the residual value of an entity’s assets after deducting all liabilities
• The accounting equation is assets minus liabilities equals equity. The stuff the business has is equal to the stuff a business owes. The equation always balances.
• The accounting equation forms the balance sheet, which is a snap of a business's assets, liabilities, and equity at a point in time

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What are assets?

In accounting, assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. All of a business's assets are on the balance sheet.

Assets are one of the three pillars to the accounting equation. Assets are what businesses use to operate and generate a profit. There are different types of assets such as current, noncurrent, tangible and intangible. 

Current assets are ones that we can convert into cash in a short period of time, usually under one year. A few examples are cash, accounts receivable, and inventory.

Non-current assets are long-term assets that can’t easily be converted into cash. An example are long-term investments that we plan to hold onto more than one year. Typically you do not expect to turn a non-current asset into cash within a one year period, and therefore it is non-current or a long-term asset.

Tangible assets or fixed assets are the ones that have an actual physical presence. A few examples are land, buildings or PPE (property, plant and equipment) such as furniture, machinery and cars.

Intangible assets are ones that do not have a physical presence such as intellectual property, patents, royalty rights, trademarks, and copyright.

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What are liabilities?

Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Simply speaking, liabilities are something that a business owes. All of a business’s liabilities are on the balance sheet. 

Short-term liabilities are current liabilities, typically due within one year. For example accounts payable, taxes payable, accruals, unearned revenue, and short-term loans.

Long-term liabilities or non-current liabilities are typically not expected to be due or settled within one year. For example, long-term loans such as a mortgage for a business in real estate.

Contingent liabilities are a potential obligation that may arise depending on the outcome of an uncertain future event. For example, if a business is being sued, it has a potential liability of owing of significant amount of money at some point in the future.

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What is equity?

Equity is the residual value of an entity’s assets after deducting all of its liabilities. Equity represents the net assets of a business. Equity also represents the net funds invested into a business by its owners.

Depending on the entity structure, equity comes in the form of many different names and is made up of a lot of different things. 

One of the first things that makes up equity is capital contributions. This is the money that owners invest into the business out of their own pockets. The words used to describe capital contributions change depending on who the owners are, which changes based on the structure of the business. 

For example, if you are a sole proprietor, this would be called owner’s equity. For partnerships, this would be called partner’s contributions. For a corporation, this would be called shareholder’s equity.

A second thing that affects equity are distributions. This is the money that owners take out of the business to use for personal reasons. The words to describe this term vary per entity. For an LLC. This is called owner’s draws. For partnerships, this is called partner distributions. For a corporation, this would be called shareholder distributions.

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What is the accounting equation?

The accounting equation lies at the heart of accounting and is the foundation of the double entry accounting system. The key principle behind the accounting equation is that stuff the business owns is equal to the stuff the business owes, and it is vitally important that you remember that this equation always balances. The stuff the business owns = The stuff the business owes. 

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How the accounting equation works

Let’s say that I started a business selling popcorn. I’ve got $5.00 in my pocket, and I decide to lend it to the business. Now, there is a word to describe the stuff that the business owns and that is called assets. 

On the other side of the accounting equation we actually have two different words to describe what the business owes, and that depends on who the lender is. We use liabilities to describe what the business owes to third parties, and we use equity to describe what the business owes to its owner. 

Assets = Liabilities + Equity

So that $5.00 that my popcorn business now has is called an asset and that $5.00 dollars is called owners equity, it balances! 

Assets can include things like cash, accounts receivable, inventory, plant property and equipment, land and buildings, investments and goodwill. Liabilities can be made up of accounts payable, loans payable, wages payable, and taxes payable. The most common forms of equity are stockholders or owners equity and retained earnings. Retained earnings is profit held for future use. 

A balance sheet is one of the most important financial statements. There is a lot you can tell about a business by looking at its balance sheet. 

If I head down to the shop and spend $5.00 on corn then I no longer have $5.00 in cash but I know have $5.00 of inventory. The categories have now changed but my total assets stay the same. My balance sheet is in balance. $5.00 is inventory (asset) and $5.00 is owners equity (equity). 

Now I need to pop this corn, but I do not have a pot. I decided to ask a friend if I can borrow $10.00. This $10.00 would go to cash and loans payable. Cash is the asset and the loans payable is the liability. 

I then go and spend $10.00 on a pot. My cash goes down by $10.00 and my equipment goes up by $10.00. The asset just changed places.  Now my equation is $5.00 inventory, $10.00 pot = $5.00 owner's equity, $10 loans payable. We are in balance!

Now let’s say I go and sell my first batch of popcorn at a 60% markup on cost. So, I made sales of $8.00. All of my inventory is now gone, however I now have $8.00 in cash and have made a small profit of $3.00. My profit is $3.00 because my sales were $8.00 and the corn cost me $5.00. Income minus expenses equals profit. Since the business made a profit, assets have increased by $3.00 (cash)  and retained earnings increased by $3.00.

You can also rearrange the accounting equation to see that Equity = Assets - Liabilities. Net assets is another term for Assets minus liabilities. So, you can say that Equity = Net Assets.

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If you are interested in understanding the accounting equation further along with increasing your basic knowledge of accounting, I highly recommend a quick and easy read: The Accounting Game, By: Darrell Mullis & Judith Orloff. The book walks you through accounting using a lemonade stand as an example. It is engaging and an interactive learning experience.

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As always, at Easeify we are here to help. If you are looking to outsource your accounting to focus on other aspects of your business, contact us today.